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Something About Bitcoin That Almost Nobody Understands

Fed Economist Explains Something About Bitcoin That Almost Nobody Understands

Apr. 7, 2014, 4:39

David Andolfatto

One of the funny things about Bitcoin is the way its terminology seems rooted in ancient monetary history.

First of all, there's the fact that it has "coin" in its name, harkening back to an increasingly irrelevant aspect of the monetary system.

And then there's the fact that to obtain coins you have to "mine" them by having your computer expend tons of electricity on seemingly pointless tasks. It seems very barbaric and ancient. And it's one reason that Bitcoin has gotten a lot of criticism.

But maybe the terminology is bad and the criticism is unwarranted.

David Andolfatto is an economist with the St. Louis Fed who recently made a presentation all about Bitcoin. Our Rob Wile interviewed him, and at one point, Andolfatto articulatedsomething on the above matter better than pretty much anyone we have heard:

BI: How have your opinions on Bitcoin evolved since that first post?DA: Early on, I thought, 'This was kind of silly,' and I kind of questioned the role of the miners, these miners who are mining bitcoin. And it led to the analogy of people mining for gold. I recall reading a blog post by Paul Krugman, who criticized Bitcoin. He was saying exactly what I was thinking: that this intensive effort to mine for gold ...We don't need more physical commodities. All that has to happen is the price level has to adjust. Economic theory says that kind of mining is inefficient.I shared in that opinion, but I continued to read about it, and it struck me that that analogy was incorrect — that in fact what these miners were, was mislabeled. They were performing a communal service, a record-keeping service which is critical to any money system. Mining was a red herring, it's just one way to reward record keepers for their service, and that protocol could function even with constant supply.This is really deep on multiple levels.

First of all, he's correct that mining is a flawed analogy. "Miners" are being rewarded for performing a task of network administration and transaction verification. One beauty of the system is that it doesn't need a centralized authority to confirm transactions because the computers on the seem are incented to take on that role.

And the last point is key too: There's actually no need for "more" coins. The creation of coins serves as a way of giving a fee to the miners (transaction verifiers) but it's not like a real commodity where you could ever have a true shortage that would require you to dig up some more. Bitcoins are infinitely divisible, and the price could rise infinitely, so there's plenty to work with. The only limiting factor is the amount of outside money people are willing to devote to it.Bottom line: Andolfatto doesn't just understand Bitcoin well for a mainstream economist. He gets it and can articulate it better than even many Bitcoin advocates.